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The New York Times: S.E.C. Seeks to Curtail Investor Suits

February 13, 2007

WASHINGTON: The Securities and Exchange Commission has begun to take steps on two fronts to protect corporations, executives and accounting firms from investor lawsuits that accuse them of fraud.

Last Friday, the commission filed a little-noticed brief in the Supreme Court urging the adoption of a legal standard that would make it harder for shareholders to prevail in fraud lawsuits against publicly traded companies and their executives.

At the same time, the agency’s chief accountant told a conference that it was considering ways to protect accounting firms from large damage awards in cases brought by investors and companies.

Critics said that the moves signaled a major retrenchment from the post-Enron changes and showed that a lobbying push by big companies, Wall Street firms and the accounting industry was gaining traction as they seek to roll back what they see as onerous regulation and excessive investor litigation.

But Christopher Cox, the chairman of the commission, said in an interview Monday that both efforts were in the best interests of investors because they aimed at preventing the accounting industry from further consolidation and at limiting what he called “fraudulent lawsuits,” including some he said were filed by “professional plaintiffs.”

Institutional investors and some analysts expressed alarm at the developments, noting that the number of shareholder lawsuits was declining significantly. “It is clear from these actions that this is a commission intent on reversing seven decades of rule making, by Democrats and Republicans, that have protected investors and opposed shielding auditors,” said Lynn E. Turner, a former chief accountant at the commission and the managing director of research at Glass Lewis, an adviser to large shareholders. “This administration and this agency are very pro-business and anti-investor.”

On Friday, the commission’s chief accountant, Conrad Hewitt, told a group of securities lawyers at a conference in Washington that because there only four large accounting firms remain, the agency had begun to consider how to limit the legal liability of those firms in suits brought by investors and companies.

Mr. Hewitt said that he had witnessed numerous meritless lawsuits against auditing firms when he was the managing partner of Ernst & Young and that the potential claims against some firms were now so large that they could lead to bankruptcy and force further consolidation in an industry that was already heavily concentrated, audience members recalled.

Mr. Hewitt also said that five European countries had already found ways to limit auditor liability and that the European Commission issued a policy paper advancing the view that the biggest firms should be given new legal protection against damage claims, audience members said.

Some countries have put a monetary cap on legal liability, while others have adopted limits based on the size of the client corporation or the fees generated by the company being audited.

Mr. Cox said the consolidation in the accounting industry had prompted both Congress and the commission to consider ways to “prevent the demise of another firm.”

“There is simply no safety net for investors,” he said. “We have no answers yet, but we are studying the question. It is in the interest of investors and issuers that there be healthy competition in the profession.”

The industry groups have been pushing Congress to adopt some of the changes, but so far have not garnered significant support, largely because of the political fears that the effort would be seen as an abandonment of some of the investor protections that were adopted after the collapse of Enron in 2001 and the huge accounting fraud scandal at WorldCom a year later.

Last November, a panel of business executives and legal experts coordinated by Hal S. Scott. Harvard Law School professor, proposed limits on shareholder lawsuits and caps on accountant liability. A committee sponsored by the United States Chamber of Commerce is completing work on similar proposals. The Big Four accounting firms have also embarked on a lobbying campaign to reduce their liability.

The groups have maintained that excessive shareholder litigation and burdensome new regulation are costing businesses too much and are prompting more companies to issue stock in overseas markets.

The Supreme Court case involves a securities fraud lawsuit by investors against Tellabs, a maker of equipment for fiber optic networks, for statements made from late 2000 to 2001 by senior executives. According to the complaint, Richard C. Notebaert, the company’s chief executive at the time, repeatedly made statements about earnings and sales of the company’s most important products that proved to be false. When the company corrected his initial statements, the company’s shares dropped to $15.87 (during the period it had been as high as $67.125).

The issue before the Supreme Court is the interpretation of a provision of the Private Securities Litigation Reform Act of 1995 that sets out what investors must contend in a fraud lawsuit to prevent the case from being dismissed. The law requires that investors state facts “giving rise to a strong inference that the defendant acted with the required state of mind.”

In reinstating the case, the United States Court of Appeals for the Seventh Circuit, in Chicago, interpreted the law to mean that the investors had to show whether the accusations, if true, would permit “a reasonable person” to infer that the company and the executives “acted with the required intent.”

The S.E.C. brief in the case, Tellabs Inc. v. Makor Issues and Rights Ltd., said that the appeals court set too low a threshold and that the law required investors to show by evidence “a high likelihood” that the defendant possessed the intent to violate the law.

The brief, which was also signed by the Justice Department, said judges ought to weigh any facts that provided for an innocent explanation of the conduct of the company and its executives. Jill E. Fisch, a securities and corporate law professor at Fordham University, said that the S.E.C. brief sought to set an exceedingly high standard for getting a case to a jury and that it was unusual although not unprecedented for the commission to side against investors in a fraud lawsuit at the Supreme Court.

“After reading the brief, one has to wonder if the S.E.C. is now on the side of the defense bar,” said Professor Fisch, who is a visiting professor this semester at the University of Pennsylvania School of Law. “This does not read like an S.E.C. brief since it does not articulate anything about the commission’s experience in the area. It reads, instead, like a litigant’s brief.”

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